Academic journal article Australasian Accounting Business & Finance Journal

The Effect of Board Independence on the Earnings Quality: Evidence from Portuguese Listed Companies

Academic journal article Australasian Accounting Business & Finance Journal

The Effect of Board Independence on the Earnings Quality: Evidence from Portuguese Listed Companies

Article excerpt

1. Introduction

Boards of directors are the primary element of corporate governance because they are responsible for monitoring the quality and the integrity of the company's financial reports and controlling top management, as delegated by shareholders (Fama & Jensen 1983). Portuguese's company law establishes that the boards of directors have the responsibility to monitor the firm's accounting system and the financial statements. Board monitoring of the financial reports is important because managers often have self-interested incentives to manage earnings, potentially misleading shareholders.

An important factor that may affect the ability of the board to monitor the firm's managers is its composition and the percentage of independent directors on the board (Fields & Keys 2003). According to agency theory, one important mechanism designed to reduce agency problems is the appointment of independent directors on the corporate board. Independent outside directors are motivated to avoid colluding with managers because the human capital value of independent directors is partially determined by the effectiveness of their monitoring performance (Fama 1980; Fama & Jensen 1983). The external stakeholders will require independent outside board members to monitor financial reporting and internal transactions, with a sufficient level of external scrutiny, and according to a prescribed set of expectations (Lynall et al. 2003). Therefore, as monitors of management, independent outside directors play an important oversight and monitoring role in corporate governance.

Previous studies based, mainly, on data of US and UK firms conclude that corporations with independent boards tend to have less earnings management (e.g. Dechow & Dichev 2002; García-Meca & Sánchez-Ballesta 2009; Koa & Chen 2004; Mather & Ramsay 2006; Peasnell et al. 2000, 2005). For example, Klein (2002), using US data, finds negative associations between abnormal accruals and the percentage of outside directors on the board, and to whether the board is comprised of less than a majority of outside directors. Similar results were also reported by Ebrahim (2007), Epps & Ismail (2009), Farber (2005), Uzun et al. (2004) and Xie et al. (2003). Peasnell et al. (2000, 2005) analyse a sample of UK firms, concluding that the likelihood of income increasing accruals decreases with an increase of the independence of the board. Garcia Osma (2008) also uses a sample of UK firms to study whether independent boards are efficient at detecting and constraining myopic R&D cuts. The results indicate that more independent boards constrain the manipulation of R&D expenditure. Davidson et al. (2005) find empirical support for the effective role of independent directors in constraining earnings management in Australian firms. This suggests that independent directors are able to better protect shareholders from managerial opportunism. Therefore, board independence may improve earnings quality by reducing earnings management. Ahmed & Duellman (2007) and Beekes et al. (2004) find that an independent board improves the quality of reported earnings for a sample of US firms and for a sample of UK firms, respectively.

Independent directors on the board may improve earnings quality by mitigating managerial self-interest and by monitoring and controlling the production of financial statements by management. Accordingly, boards with more independent directors have a propensity for greater monitoring and are therefore expected to insist on greater earnings quality. Hence, we expect that board independence will improve earnings quality by limiting earnings management.

Thus, in this study, we examine the effect of board independence (measured by the proportion of independent non-executive directors on the board) to the earnings quality, hypothesising that board independence enhance the earnings quality by limiting the extent of discretionary accruals. …

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